What you need to know about hiring independent contractors

The IRS and U.S. Department of Labor have teamed up with a growing number of states to share information and resources that might help uncover worker misclassification violations. In addition to possibly owing back pay (if minimum wage requirements haven't been met), employers in violation might be on the hook for overtime, back taxes—including the employees' portion—penalties and interest, fines, retroactive employee benefits, staff time and effort, and possible legal fees. Less quantifiable costs include negative publicity and lowered staff morale. Plus, the fines and penalties imposed increase the more willful the violation.

The IRS is clear that there is no magic formula to determine whether or not a worker is classified as an independent contractor or an employee—it depends on the specific facts of the case. In general, employers can start by considering whether they have the right to control not just the work outcome but how the worker performs the work. Whether or not you actually exercise this right is irrelevant to the worker's status. There are times, for instance, with highly experienced employees, when organizations provide little guidance or oversight. The question is whether you have the right to.

How does the IRS decide upon the degree of control an employer has over how the work gets done? The IRS' Common Law Rules cover factors in three main categories: Behavioral Control, Financial Control and Type of Relationship. No one factor is decisive—the totality of each situation must be evaluated.

You can also take the Department of Labor's Economic Reality Test [PDF], which relates to whether the Fair Labor Standards Act (FLSA) applies. Its six factors overlap those of the IRS. It also considers whether or not the worker has a bona fide business that does not provide services integral to yours. 

So how do you prove that someone is indeed an independent contractor and not an employee? The best documentation shows the person has a bona fide business separate from yours. Documentation can also show the worker fully controls his or her work, the work he or she provides is not an integral part of what your business provides and the worker is free to make a profit or loss and be hired by others (check with the IRS for further information). In addition, keep a vendor file for each independent contractor that includes the following:

A written contract. Outline the nature of the relationship since merely saying the person is an independent contractor doesn't make it so. Indicate the project's expected results, fee and date(s) of completion. The contract should state the worker should use his/her own equipment/tools, is free to hire others without your approval, and that he or she provides liability insurance for his/her workers. Note the contractor's business and tax I.D. number. Make sure the contract is signed by both parties and create a new contract for each new project. 

Proof of a real and separate business. Keep a copy of any letters on business stationery, business cards, brochures, or advertisements. Print a copy of an appropriate page of the contractor's website, online advertisement of services or copies of emails detailing services offered. 

Invoices. Base all payments to the contractor on their submitted invoices. An independent contractor shouldn't submit expense reports to you. Mileage and any equipment or supply purchases should be part of their business expenses, not yours. Keep all invoices, and make sure they match up with Form 1099, which you'll need to provide the contractor at the end of the tax year.

Form W-9. Keep a properly completed W-9 on file for each independent contractor. If the contractor does not check the box exempting himself or herself from tax withholding, you are legally obligated to withhold taxes at 28%. An independent contractor should check that box and file their own self-employment taxes. 

With today's stricter employment laws, it's important that businesses do their homework before simply classifying someone as an independent contractor. The following situations may raise red flags as far as an independent contractor's status:

• A former employee is rehired to do work similar to their old job, even if temporary or part-time
• An intern is doing actual work, not just shadowing or learning; be sure to check the six criteria related to interns [PDF]
• You provide the equipment, supplies, tools, or ongoing office space the worker uses
• The worker replaces one of your employees or supervises any of your employees
• The relationship is ongoing and long-term, rather than project-based

A final caveat is that state laws may differ from federal laws in important ways. It's possible for a worker to be classified as an independent contractor for IRS purposes yet, by state definition, have workers' compensation or unemployment insurance premiums paid on their behalf. Be sure to check your state's laws on independent contractors and really cover your bases.

For nearly ten years, HRSentry has helped organizations across the country navigate the tricky world of human resources. Their online tools have been developed to save time, resources and money. For more information, call 1-800-523-2564.